States and the Markets

While the federal government remains stymied over corporate misdeeds,
state officials have come out with guns blazing.

The American model of capitalism has been the guide for the world. Its great transparent, rules-based securities markets have been the place where the invisible hand works its magic, doling out billions in capital to the brightest and best.

Today, many disappointed investors wonder if the invisible hand is being manipulated to pick their pockets. President Bush may be right when he says there are only a few bad corporate apples. But the unstinting outpouring of earnings write-downs, tax evasions and securities law infractions suggests there may be bushels of them, and they tend to be really big as well as very rotten.

According to The Economist magazine, almost 1,000 major American firms have restated their earnings since 1997. The slow-to-anger Securities and Exchange Commission now has twice as many fraud investigations underway as it did a year ago. Perhaps more startling is the long list of corporate icons that have been toppled by transgressions.

The stock markets are not the only problem. Through much of the 1990s, the U.S. government was a net supplier of funds to the markets. Thanks to historic tax increases passed in the early 1990s, the national government, freed of years of heavy defense spending, was fiscally prudent. Deficit-free, the yoke of federal spending became relatively light and easily financed.

That is all gone. Now, the federal government, having sawed off a chunk of its tax base last year, is back into deficits as far as the eye can see. There is little congressional vigor to balance expenditures and revenues. A point so often lost on ardent anti-taxers was that the federal surplus buoyed the savings rate and freed up funds for other, more productive uses.

Beyond the budget itself, however, there's another deficit that few pay much attention to--the trade deficit. We have not had to pay attention to that because foreigners were more than happy to finance our trade deficits by investing in our securities markets. Now, they are leaving our markets and selling their dollars.

There may be little that local governments can do about these crises in confidence, but that is not so with the states. One of the virtues of our expensive and convoluted system of federalism is that if one level is stymied, another will act. Already, state officials have come out with guns blazing (that is, lawsuits) in response to the host of corporate scandals. The efforts of New York Attorney General Eliot Spitzer awakened a somnambulant SEC. State attorneys general, who are elected officials with broad investigative powers, are proving to be a force to be reckoned with. Both congressional committees and corporate lobbyists (including Wall Street and accountant associations) have been trying to nip off the state-based assault on such issues as corporate governance, securities regulation and accounting practices. The splintering of regulations among the states, of course, is a threat. But the countervailing menace, and a larger one to many, is that congressional inaction and regulatory lethargy in Washington will fail to address the problems.

But perhaps most influential will be the huge economic power that states (and some localities) possess in the shape of their pension funds. These systems are major investors. The funds' ability to earn healthy rates of return on investments is critical to the future benefits of public employees and the fiscal well-being of government employers. Up until a couple of years ago, the systems looked like heroes, consistently ringing up double-digit gains in investments. That meant lower contributions from employees and employers (which translated into lower taxes), better benefits and stronger financial conditions.

Ever since taking a bath in Enron investments, the public employee pension systems have been getting aggressive. The state systems of New York and North Carolina recently announced plans that would subject securities firms that want to do business with them to new standards, including guaranteeing that the firms' analysts are not moonlighting in conflict-of-interest roles. Several public pension systems are on the case in the Enron scandal, and the Ohio retirement system has taken the lead in pursuing the paper-shredding excesses of Global Crossing. Mighty TIAA-CREF, with $270 billion under management as the defined contribution system for 2.4 million public workers, including teachers and researchers, says it will use its stock ownership to shape up corporate governance.

These efforts are not political fig leaves. State and local pension systems are big-time investors and their mandates are clear. Unlike private funds, they are seldom conflicted by going public with complaints or angering particular corporations. They really do care about corporate performance and, observing the secular "golden rule," have the clout to make things happen. Now is their time to act.